Chapter 3 The Decision Usefulness Approach to Financial Reporting

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Chapter 3The Decision Usefulness Approach to
Financial Reporting
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Single-Person Decision Theory

• Perfectly Specified Decision Process

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Basic Decision Process
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Decision Theory Model

• A model of rational decision making in the face
  of uncertainty
• Another example of analytical research
• Makes simplifying assumptions
• Rational economic man approach
• Perfectly specified decision process
• Concept of an Information System can be
  introduced and modeled

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AssumptionRational Economic Man

• Has complete information
• Prefers more to less
• Can express clear preferences among commodities
• Preferences are always transitive
• Able to maximize expected utility

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Example
Consider an investor with 10,000 to invest in
one of the following mutually exclusive
acts a1 buy shares of x Ltd. For 10,000 a2
buy Canada Savings Bonds (CSB) for 10,000 Let
there be 3 states of nature ?1 shares fall
10 in market value ?2 shares hold steady ?3
shares rise 80
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Example, cont
Payoff Table Prior Probabilities
P(?1) .05 P(?2) .70 P(?3) .25 1.00
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Example, cont
Assume the investor uses expected monetary value
as a decision criterion (EMV) EMV (a1)
(.05)(-1000) 0 .25(8000) 1950 EMV (a2)
(.05)(1000) .70(-1000) .25 (1000)
1000 Therefore, if investor acts now, should
take a1. But May be worthwhile to secure
additional information.
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Decision Problem
Think of the financial statements of X Ltd. as an
information system conveying information about
probabilities of ?. Assume the financial
statements will give one of the following 3
mutually exclusive messages
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Bayes Theorem (Rule)

• The basic principle of Bayes' Theorem is that
  additional information can change a decision
  makers prior beliefs about the occurrence of an
  event

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Decision Problem, Cont.
The information system can be characterized by
the following table
These conditional probabilities, or likelihoods,
are the probabilities of receiving the various
messages conditional on each state being true.
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Decision Problem, Cont.
Now, for any message, the decision maker can
revise his/her prior probabilities using Bayes
Theorem. Suppose that m1 was received from the
financial statements.
Then
P(m1)
Similarly
.85 .06 1.00
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Decision Problem, Cont.
Note the EMV of each act is
So if m1 were received act a2 would be chosen.
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Decision Problem, Cont.
You should verify that if m2 was received
where
And the optional act is then a1 with EMV of
1444.48.
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Decision Problem, Cont.
Similarly, if m3 was received
where
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Preference for Risk
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Risk Preference Depends
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The Information System

• One of the most important text concepts
• Conditional on each state of nature (i.e., future
  firm performance), gives objective probability of
  the GN or BN in the financial statements

Go to Excel to illustrate perfect information
system and a useless information system
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Information Defined

• Information is evidence that has the potential to
  affect an individuals decision
• An ex ante definition
• Individuals receive information all the time
• Individual-specific
• Are financial statements information?

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The Rational Investor

• Definition
• Maximizes expected utility, using the
  single-person decision theory model
• May be risk averse
• Then, will diversify
• Needs information about risk as well as expected
  return
• Portfolio theory
• Review from finance courses youve had

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Objective of Chapter

• Decision theory is a useful intellectual model
  particularly when applied to aggregate behavior
• Captures average investor behavior?
• Helps us understand how financial statement
  information is useful
• Rationale in Concepts Statements
• FASB SFAC No. 1 No. 2

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Real People

• People cant always express preferences among
  commodities
• People dont always prefer the cheap to the
  expensive
• Preferences are not always transitive
• Economic agents rarely, if ever, act on the basis
  of complete information
• Economic agents do not, in general, maximize
  their preferences
• Preferences are not stable over time

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Decision Making

• Despite human imperfections
• An organized process is desirable!

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Modern Portfolio Theory
Figure 1 Portfolio optimization for oil and gas
investments. Source Don Merritt, Merak
Projectshttp//www-128.ibm.com/developerworks/rat
ional/library/aug05/mckenna/index.html
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Beta

• Definition
• Standardized covariance between return on share
  and return on market
• Only relevant risk measure for a reasonably
  diversified investor
• Why? Because firm specific risk diversifies away
• Implication investors dont need accounting
  info?